Here are Dechert's Top Twelve Regulatory Hot Topics from Hong Kong and around the world – to focus on and deal with in the new year, after all the festivities!
1st Day of Christmas – UCITS V*
The UCITS V Directive (UCITS V) introduces specific provisions on:
- eligibility, liability and delegation of depositaries;
- remuneration policies; and
- new administrative sanctions and provisions encouraging whistle-blowing.
European governments have until 18 March 2016 to transpose UCITS V into national law. The European Securities and Markets Authority (ESMA) issued its final technical advice to the European Commission (EU Commission) on 28 November 2014. ESMA and the EU Commission are currently preparing delegated acts based upon this technical advice. It is expected that UCITS V will align (i) the regulation of UCITS custodians and the remuneration policies of asset management companies with (ii) the corresponding regulations and policies imposed on such service providers under the Alternative Investment Fund Managers Directive (AIFMD).
In relation to depositaries, UCITS V requires such entities to be an EU credit institution or an EU investment firm with its registered office or a branch in a UCITS home Member State, and also imposes stricter standards of liability on depositaries for almost all losses incurred by the UCITS in question, as well as all losses resulting from the depositary’s own negligent or intentional failure.
*The authors appreciate the contributions of Antonios Nezeritis.
2nd Day of Christmas – Open-Ended Fund Companies (OFCs) in Hong Kong
At the moment, a Hong Kong-domiciled open-ended mutual fund can only be structured as a unit trust – not as a corporation or company – due to restrictions in the Companies Ordinance on the redemption of shares. The industry has lobbied for many years for legislation that would allow HK-domiciled open-ended vehicles to be structured as corporations.
The proposed OFC legislation would allow such HK-domiciled open-ended corporations to be established, with at least two directors – one of whom must be HK-resident. Publicly distributed funds structured as OFCs would need to go through the usual fund authorization process with the Securities and Futures Commission (SFC), but the proposed legislation goes further to suggest that even privately distributed OFCs must be “registered” with the SFC, although it is not yet clear what form such “registration” would take.
Currently, privately placed funds are not subject to any requirement to register with or to notify the SFC before they may be privately placed. If adopted, a requirement that privately placed HK-domiciled OFCs be registered would mean that they will bear a higher burden than non-HK domiciled funds that are privately placed, unless the intention is to extend such registration requirement to non-HK domiciled funds as well.
Additionally, the investment manager(s) and custodian of an OFC would need to be Hong Kong-based and (in the case of the investment manager) licensed and regulated by the SFC. These are even higher eligibility thresholds than are currently imposed on publicly available retail funds.
3rd Day of Christmas – Unlisted Fund Distribution Platforms
Hong Kong’s Financial Services Development Council (FSDC) has proposed the establishment of a fund trading facility on the Hong Kong Stock Exchange, as one of a number of developments designed to improve fund distribution in Hong Kong and strengthen its position as a fund distribution centre. If established, such a trading facility – together with the growth of online fund distribution platforms – may be what is needed to make a dent in the control currently exercised by banks on mutual fund distribution in Hong Kong.
Similar trading facilities have been launched in South Korea and Australia with varying degrees of success, and are also being considered in Taiwan.
One hurdle to overcome in ensuring the success of such distribution platforms is dealing with the Know-Your-Client (KYC) requirements imposed by local regulations in order to facilitate online subscriptions for funds. One novel solution which appears to have cleared this hurdle is the centralized KYC system implemented in India by the Indian securities regulator, which covers the entire financial industry including mutual funds. The Indian system provides a streamlined process by which investors are deemed to satisfy the KYC checks once the investors have established a permanent account in the centralized KYC system.
Such a system is a far cry from the fragmented approach to KYC checks that now exists in the financial industry in Hong Kong. It remains to be seen whether the recommendations of the FSDC will gain traction and come into fruition.
4th Day of Christmas – Liquidity Risk Management
The U.S. Securities and Exchange Commission (SEC) recently proposed disclosure and reporting requirements for registered investment funds and ETFs, related to their liquidity risk management and swing pricing policies. In the EU, regulators have indicated that the liquidity risk management tools (including stress testing) that have been built into the UCITS and AIFM Directives are sufficient.
In Hong Kong, the SFC has indicated that no Basel-like regulations are generally required for the asset management industry, as risk is more likely to rest with the large global systemically important financial institutions. Anecdotal evidence from the SFC’s recent routine inspections of licensed corporations and intermediaries, however, would indicate that the SFC is indeed focused on the issue of liquidity risk management by asset managers and, in particular, on the following:
- whether there is independent liquidity management;
- the stress testing tools currently in place;
- whether there is offsite risk management;
- the extent of preparation for market shocks; and
- whether appropriate disclosure regarding product risk is set forth in the offering documents or client agreement.
Licensed corporations would do well to review and, if appropriate, enhance their internal controls to address these issues.
5th Day of Christmas – Changes to Hong Kong’s Professional Investor Regime
With effect from 26 March 2016, Hong Kong’s Professional Investor regime will undergo a significant change – the first since the regime was introduced in 2003, when the Securities and Futures Ordinance (SFO) came into force.
Currently, licensed corporations are permitted to forego compliance with certain provisions and requirements of the Code of Conduct of Persons Licensed by and Registered with the SFC (Code of Conduct), as long as the client/investor is a “professional investor” as defined under the SFO and the Securities and Futures (Professional Investor) Rules.
From March 26 of next year, however: (i) all individual professional investors will be treated in the same manner as retail investors; and (ii) corporate professional investors will be subject to an assessment to determine the suitability of products recommended to them for investment or in which investments are made in their name. The criteria for such assessment are set out in the SFC's circular of January 2015.
Intermediaries with such clients must ensure that their compliance manuals are appropriately revised/enhanced, so that frontline staff who may come into contact with potential clients will be well aware of how to treat the individual professional investor and how to assess the corporate professional investor. Relevant client agreements should also be revised to include a detailed description of the services to be provided to the particular client.
6th Day of Christmas – WFOEs to Carry Out Private Fund Management
The Chinese authorities had pledged in July this year to allow foreign asset managers to carry out onshore private fund management activities using a Wholly Foreign Owned Enterprise (WFOE), which would enable such managers to sell private funds directly to institutional investors and high net worth individuals based in China. As a demonstration of the Chinese authorities’ commitment to follow through on this pledge, in September Aberdeen Asset Management set up a WFOE with a business license specifying that it is permitted to engage in “investment management.”
There have not been any specific regulatory updates or guidance issued with respect to this new development, nor has there been any indication as to the date when Aberdeen Asset Management (and others to follow) may commence engaging in onshore investment management. Further, a WFOE with this expanded scope of business activities will still need to be registered with the Asset Management Association of China before it may conduct investment management activities. As such, there remains much uncertainty in this area. The industry, especially foreign fund managers, will be monitoring this space closely.
7th Day of Christmas – Mutual Fund Recognition
The Hong Kong–Mainland China Mutual Fund Recognition Scheme (MRF) introduced this past May became operational on 1 July 2015, and applications for both northbound and southbound offerings are currently well underway. It is anticipated that the first funds will be registered for sale by the end of 2016. This is a delay from initial projections, which had anticipated the sale of mutually recognized funds to commence by the end of 2015.
The Hong Kong and Taiwanese regulators have also been in talks recently to establish a mutual fund recognition arrangement, similar to the MRF, whereby funds authorized for retail distribution in one jurisdiction may be offered directly in the other. However, these talks are still at a very nascent stage and details about how this arrangement will work in practice have not yet been made public. This arrangement is expected to lead the way for a wider three-way mutual fund recognition scheme among Hong Kong, Taiwan and China. However, there will be challenges in working towards this, including overcoming the differences in local regulations, conflicting tax regimes and varying levels of investor protection. The sensitive political relationship between Taiwan and Mainland China is also anticipated to be a hurdle that will need to be overcome in order to implement a successful mutual recognition scheme.
8th Day of Christmas – Shenzhen Stock Connect
Since its commencement in November 2014, the Shanghai-Hong Kong Stock Connect has provided international investors with the ability to trade Shanghai-listed equities via Hong Kong brokers and the Hong Kong Stock Exchange. While the Shanghai-Hong Kong Stock Connect’s early trading volumes were viewed by some as underwhelming, it eventually found users among U.S. retail funds and ERISA vehicles, Luxembourg UCITS, and even Irish UCITS.1 With Stock Connect gradually gaining acceptance, the Chinese government issued a report in March 2015 stating that China’s second stock exchange – the Shenzhen Stock Exchange – would be added to the Stock Connect program “at an appropriate time.”
After volatility hit the Chinese stock markets in June this year, many market commentators assumed that Shenzhen Stock Connect would be delayed until 2016. This view was briefly challenged when a newspaper article, published in November, quoted the head of the People’s Bank of China as stating that an agreement to launch Stock Connect in Shenzhen was “imminent.” Hong Kong Exchanges and Clearing Limited, the operator of the Hong Kong Stock Exchange, quickly announced that, in fact, no agreement had been reached. The People’s Bank of China subsequently issued an explanation: the quotes in the article were actually from a speech given in May 2015, before the stock markets suffered their losses. As a result, the launch of the Hong Kong-Shenzhen Stock Connect remains uncertain, although it is widely expected to occur in 2016.
9th Day of Christmas – Hong Kong SFC Consultations on OTC Derivatives
Consistent with an informal, but long-standing, tradition, the SFC issued a number of consultation papers before the holidays. These consultations propose, among other items, rules to implement mandatory OTC derivatives reporting and clearing, as well as changes to Hong Kong’s capital requirements for regulated entities. Fund managers and funds were largely carved out from the initial stages of mandatory reporting.2 The recent proposed expansion of reportable OTC transactions did not expand the parties that would be subject to the requirements.3 The same consultation proposed a framework for the implementation of mandatory OTC clearing in Hong Kong, and fund managers, once again, would be excepted from the proposed rules. Mandatory clearing would be implemented in phases, and the initial phase would cover only clearable transactions between large dealers.4
While this staggered approach has been welcomed by many fund managers, it will be important to watch how the SFC implements OTC reporting and clearing, and to provide feedback to the SFC if any elements of OTC reform are unworkable in practice for funds and fund managers.
10th Day of Christmas – the Common Reporting Standard
Just as fund managers in Asia have finally tamed FATCA and “UK FATCA” tax registration and reporting, the global equivalent to FATCA is set to take effect. The Common Reporting Standard (CRS) imposes investor due diligence and reporting obligations on funds and other financial institutions that are domiciled in the Cayman Islands and other common fund domiciles in Europe and the Caribbean from January 1, 2016, and in Hong Kong, Singapore and China from January 1, 2017.
While broadly similar to FATCA, CRS requires due diligence and reporting with respect to account holders based in any CRS jurisdiction—and there are nearly 100 participating jurisdictions. To meet these deadlines, funds will need to very quickly update their offering documents and subscription agreements to contain the information required by the CRS.5
11th Day of Christmas – A Reminder to File U.S. Forms D
Funds that are sold into the United States often rely on a Regulation D private placement exemption from securities registration requirements. One of the elements of Regulation D is that a fund must file a notice of any U.S. sales on Form D for each new offering of securities, within 15 calendar days from the first sale in the offering. Regulation D also requires an annual amendment to Form D for ongoing offerings (e.g., for a hedge fund that is offered continuously to investors).
Non-compliance with these filing obligations does not invalidate the effectiveness of the private placement exemption. But there are signs that the SEC is taking these filing obligations seriously – in 2013, the SEC staff proposed rules that would disqualify issuers from using Rule 506 of Regulation D for one year if the issuer or its predecessors or affiliates failed to comply with filing obligations during a five-year “look-back” period.6 Final rules have not been issued, and it is unclear when this may occur. However, proposals such as this, coupled with the SEC enforcement staff’s current focus on relatively minor compliance violations – or “broken windows” approach – suggest that it is prudent to review how funds are using the U.S. private placement regime, and to stay current with Regulation D filing requirements.
12th Day of Christmas – U.S. SEC Examinations and Exempt Reporting Advisers*
Following the SEC’s implementation of Dodd-Frank reforms, many private fund managers in Asia became “exempt reporting advisers” in the United States. Exempt reporting advisers are not subject to full SEC registration but must periodically provide certain information to the SEC on Form ADV. At the time of adoption of the relevant rules, then-SEC Chairman Mary Schapiro stated that the SEC did not expect to subject exempt reporting advisers to routine compliance examinations. Practitioners had generally interpreted this statement as an indication that examination authority would be used to investigate a tip or complaint, rather than enforcement authority.
Marc Wyatt, Director of the SEC’s Office of Compliance Inspections and Examinations, recently indicated, in a speech in Washington D.C. to the ABA Hedge Fund Sub-Committee, that the policy is in fact broader than that, and there could be other indications that an examination of an exempt reporting adviser would be appropriate. It remains to be seen what tangible effect the policy may have for exempt reporting advisers in Asia – many Asian private fund managers have only limited contact with the U.S. market and arguably should not be the focus of SEC compliance efforts. But taken in tandem with the SEC staff’s “broken windows” approach to enforcement, the policy should be taken into account by private fund managers.
*The authors appreciate the contributions of David Vaughan.